Lithium Market Losing Track Of Fundamentals?

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Demand for lithium is being driven by the surging take-up of electric vehicles and supply is tight so prices in China have soared. Yet has the lithium market reached its zenith?

-Chinese lithium prices soar, triggering a supply response
-Yet have stocks overshot the fundamentals?
-Should investors take profits in lithium stocks now?
 

By Eva Brocklehurst

A tight market in lithium has caused a sharp rally in Chinese prices but has the market now lost track of the fundamentals? Credit Suisse suspects so. The broker anticipates further price support in the short term may stem from momentum trades and remains cautious around extrapolating too much from the current dynamics.

Demand for lithium is being driven by the take-up of electric vehicles, with total sales for the year to date almost the same as for the whole of 2020. Macquarie notes sales of pure electric passenger vehicles were up 149% in the year to July.

Europe has dominated sales overall with 63% market share while China has been the leader in 100% EV with a 53% market share. Macquarie expects total EV sales to hit 5.83m vehicles in 2021, representing 6.5% of global vehicle sales.

A rally in spodumene, with realised prices reaching US$950/t, has triggered the same for lithium carbonate and Macquarie continues to expect the price will be supported in the short term as downstream processors source lithium carbonate to feed smelters in China.

A tight market in lithium may continue, as increasing battery demand has been met by limited supply, yet Morgan Stanley believes prices in China are way too high and this signals downside.

In China, lithium carbonate and hydroxide prices have risen to above US$18,000/t and although other markets are on a positive trend the broker notes carbonate import prices in Japan and South Korea remain below US$10,000/t and hydroxide between US$11-12,000/t.

The broker believes supply is already responding to higher prices that should lead to a lithium surplus in 2022. This should drive prices down, probably in the second half of that year, when Morgan Stanley forecasts carbonate prices to reach US$8000/t.

The broker also believes new policies under discussion by left-wing parties in Chile will also affect perception of the risk profile of lithium production in that country and the continuity of the SQM operations in Atacama.

Spodumene prices will go higher given the tightness in supply and the potential margin that can be captured and Credit Suisse has outlined a “blue sky” lithium price scenario that envisages lithium carbonate reaching US$21,000/t and spodumene reaching US$1700/t in the short term, yet this then could impede battery competitiveness and temper enthusiasm for any upside.

The broker's base case price calculations imply margins close to 40% for Chinese factories that are processing lithium carbonate and hydroxide from spodumene. This appears implausibly high for a conversion process, and is not sustainable as the industry has no barriers to entry, while such margins will attract competitors.

Moreover, lithium miners are building hydroxide plants in Australia and there are more Chinese factories under construction. Credit Suisse believes the conversion industry will subsequently lose its pricing power and surrender its margins to miners upstream, where the real tightness lies, and slightly softer carbonate and hydroxide prices will advantage cathode/battery makers downstream.

The broker has a preference to buy sectors where all news flow appears negative and the stocks are trading at discounts to valuation, taking profits in sectors where all momentum is positive, suspecting the latter situation may now have approached for lithium.

Lithium Producers

Are equity valuations disconnected from the industry? Even assuming its blue sky projections, Credit Suisse struggles to justify much upside to equity valuations on a discounted cash flow (DCF) basis.

There may be price support on a multiples basis, should spot prices continue to rise and if contract pricing follows suit, but the broker believes DCF fundamentals should still matter and if there is no DCF upside from this blue sky scenario then investors should be wary.

Credit Suisse anticipates the next big move up in value for Pilbara Minerals ((PLS)) and Orocobre ((ORE)) could be to use their expensive scrip to enlarge their footprint via scale and/or geographical expansion, or even into potential future battery supply chain disruptors.

Still, making sure that existing strategies are not disrupted in the process would be key for Pilbara Minerals, in particular, to retain market trust. The broker has recently downgraded both Pilbara Minerals and Orocobre to Underperform on valuation grounds.

Even the best managed businesses have a price limit and Credit Suisse believes this these two have exceeded that. A correction should ensue but the timing and catalysts are hard to identify.

Credit Suisse retains a preference for Pilbara Minerals over Orocobre given its track record and above-ground risk profile while, in contrast, Ord Minnett flags Orocobre as its top lithium stock.

Macquarie's preference is for Australian-based producers of lithium with Pilbara Minerals as the top pick as it offers strong production growth. Mineral Resources ((MIN)) is also a preferred stock with exposure to the broader resources sector while Orocobre offers unique exposure to both lithium brine in South America and spodumene production in Australia.

Macquarie emphasises the Liontown Resources' ((LTR)) Kathleen Valley is one of the largest development projects with offtake available to third parties.

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